Question

“Ouch! Is that Deluxe model ever a loser! I say the time has come to cut back its production and shift our resources toward the new Finest model!” said Rachell Warner, executive vice-president of Wedgewood Acres Ltd.”Just look at this statement I’ve received from accounting. The Finest is generating more margin and significantly more profit than the Deluxe, and it has only about 40% as much in sales. I am convinced that our future depends on the Finest.” The year-end statement to which Rachell was referring follows:

Wedgewood Acres Ltd.

Income Statement

                                              Product Model

                                                          Total                                      Deluxe                  Finest

Sales ……………………………… $10,200,000                         $ 7,200,000           $ 3,000,000

Cost of goods sold ……………….     7,860,000                             6,120,000               1,740,000

Gross margin ……………………..     2,340,000                             1,080,000                1,260,000

Less selling and

administrative expenses ……….       2,004,000                              1,494,000                  510,000

Operating income(loss) ..………     $ 336,000                             $ (414,000)                $ 750,000

Number of units produced

and sold ……………………….              -                                        36,000                        12,000

Net income (loss) per unit ……….         -                                     $(11.50)                       $62.50

“The numbers sure look that way,” replied Con Artist, the company’s sales manager. “But why isn’t the competition more excited about the Finest? I know we’ve only been producing the model for three years, but I’m surprised that more of our competitors haven’t recognized what a cash cow it is.”

“I think it’s our new automated plant,” replied Rachell. “Now it takes two direct-labour hours to produce a unit of the Deluxe and one direct-labour hour to produce a unit of the Finest. That’s considerably less than it used to take us, especially for the Finest.”

“I agree that automation is wonderful,” replied Con. “I suppose that’s how we’re able to hold down the price of the Finest. Lavel Company in Quebec tried to bring out a Finest but discovered they couldn’t touch our price. But Lavel is killing us on the Deluxe by undercutting our price with some of our best customers. I suppose they’ll pick up all of our Deluxe business if we move out of that market. But who cares? We don’t even have to advertise the Finest, it just seems to sell itself.”

“My only concern about automation is how our manufacturing overhead rate has shot up,” said Rachell. “Our total manufacturing overhead cost is $3,612,000. That comes out to be a hefty amount per direct-labour hour,but Mabel down in accounting has been using direct-labour hours as the base for computing overhead rates for years and doesn’t want to change. I don’t suppose it matters so long as costs get assigned to products.”

“I’ve never understood that debit and credit stuff,” replied Con. “But I think you’ve got a problem in production. I had lunch with Joanne yesterday and she complained about how complex the Finest is to produce. Apparently they have to do a lot of setups, special soldering, and other work on the Finest just to keep production moving. And they have to inspect the majority of units.”

“It’ll have to wait,” said Rachell. “I’m writing a proposal to the board of directors to phase out the Deluxe. We’ve got to bring our bottom line up or we’ll all be looking for jobs.”

In preparation for the proposal further information was gathered by the accounting staff:

Prime Costs per unit produced:

                                                   Deluxe   Finest

Direct materials …………….        $60       $90

Direct labour ………………..         24         12

Total Manufacturing Overhead:

Indirect labour                           $ 596,000

Indirect materials                       1,232,000

Equipment depreciation                800,000

Supervisor salary                          184,000

Quality Control inspector salaries 800,000

Total                                            $ 3,612,000

All overhead costs are considered directly traceable to the two models produced.

Total Selling and Administrative expenses:

Head office administration $ 1,800,000

Commissions                          204,000

Total                                   $ 2,004,000

The administration costs are all fixed and are common and untraceable. However, Mabel has arbitrarily allocated the cost between the two models based on the percentage of units sold of each product to total units sold.

The commission rate is 2% of sales. This rate applies to both models.

Required:

1. Re-state the traditional income statement prepared above as a contribution format income statement. Show a separate line item on the income statement for every component of product costs (all overhead items), and selling and administrative costs. (Hint: For overheads, the basis for allocating total overhead is the same basis for calculating individual overhead costs).

2. Compute the predetermined overhead rate that the company used during the year. This rate only needs to be calculated on the total overheard. You do not need to break it down into the individual components.

3. Using the costs given and the rate computed in Part 2 above, determine the unit product cost of each model. Break down that product cost into the three cost components.

4. The company is considering implementing an activity-based cost system. The accounting staff gathered the following information regarding the activity cost pools and measures. Also they analyzed staff and operations and determined the distribution of resource consumption. The results of the analysis are given below:

                                                                                    Activity                              Activity for each model

Activity Cost Pool               Activity Measure             for the year                           Deluxe          Finest

Production planning          Number of plans               1,200 plans                           800                400

Moving product                  Number of hours              2,400 hours                        1,680                720

Machine setup                   Number of setups            3,200 setups                       2,000            1,200

Machine operation             Machine hours               140,000 MH                        60,000           80,000

Soldering                           Number of solder joints    400,000 joints                 120,000         280,000

Quality control                   Number of inspections       18,000 inspections            8,000           10,000

                                                                   Distribution of Resource Consumption across Activity Cost Pools

                                                             Production    Moving       Machine    Machine                          Quality

                                                             Planning         Product      Setup         Operation     Soldering Control

Indirect labour                                         -                    30%            70%              -                   -              -

Indirect materials                                    -                      -                25%                -                75%            -

Equipment depreciation                         -                     -                -                 100%             -               -

Supervisor salary                                  80%                 -                -                    -                  -             20%

QC inspector salaries                           15%                  -                  -                    -                  -             85%

4. Prepare a schedule that computes and presents the amount and the rate for each of the six cost pools.

5. Prepare a schedule detailing the allocation of the overhead between the two models.

6. Similar to Part 3 above, determine the unit product cost of each model. Break down that product cost into the detailed cost components.

7. Based on your analysis, would you support a recommendation to expand sales of the Finest? Explain your position, using your data to support your position.

8. If you were president of Wedgewood Acres Ltd. what strategy would you follow from this point forward to improve the company’s overall profits?

9. Based on your analysis, why do you suppose the Finest “just seems to sell itself?”

Answer 1